Bailout Plan Will Be Drag On Fragile US Economy

If you’ve been worried about the health of the economy and you also have doubts about the soundness of the Treasury’s Wall Street rescue plan, then be afraid, be very afraid—because the US economy may get a taste of what Japan’s suffered over a decade-long period.

“The Wall Street mess will now have collateral damage to the real economy,” says Steve Hanke, a former White House economist. “We're coming into this thing in a terrible situation.”

Hanke and other economists see some similarities with Japan’s decade-long economic malaise – combination of real estate asset bubble, banking crisis and misguided and expensive government intervention.

“A lot of the symptoms of the pain and adjustments will be exactly the same, “ says Hanke, now with the Cato Institute and Johns Hopkins University. “We've got some major adjustments coming in the economy, some major slowdowns.”

Depending on who you ask, that means anywhere between two to five years of no growth or slow growth, while the government rescue plan plays out along, the housing and real estate sectors stagger to recovery and the American consumer restores his own shaken balance sheet.

Opponents of the $700 billion plan see no payoff for the real economy. “This plan is not about housing, not unless you’re talking about investment houses,” says FAO-Economics Chief Economist Robert Brusca. “This is not a plan aimed at reviving the economy. This is all about trickle down.”

Even those who view the plan as necessary but insufficient see hard times ahead.

“The consumer needs repair, job layoffs are increasing, real wages are not increasing,” says money manager James Awad, managing director at Zephyr Management. “In the corporate sector, everybody’s in a protect-your-balance–sheet-mode. Most corporate executives are going to think cash is king. Overseas economies are slowing, which means exports are going to be a bit slower. So, that leaves the government and the government is constrained by huge deficits.”

Are we there yet? Sorry, but no.

“This is the beginning of the adjustment and the Fed and Treasury intervention is slowing that down,” says economist Ram Bhagavatula, managing director at the hedge fund Combinatorics Capital. “Its not like this economy is ready to go if credit is cheap and flexible.”

“I think it is horrendous,” says former FDIC Chairman William Isaac. “There are less expensive ways to stabilize depositors if people are nervous.”

Isaac notes that there were some 3,000 bank and savings and loan failures between 1980-1991; depositors didn't panic “because they had confidence in the government,” says Isaac, now chairman of the Secura Group of LECG.

Japan Vs. US Cases

Most economists say the Japanese government made the mistake of extending the country’s financial problems by one form of intervention or the other – corporate aid packages, repeated stimulus packages with one-off tax rebates that consumers didn’t spend and ever lower interest rates. The stock market sank and then languished for years.

Pimco's El-Erian on the Markets

Discussing how the government will likely make money in several areas, with Mohamed El-Erian, Pimco co-CEO

In the US, the economy is suffering from both conventional and extraordinary forces. There’s the unwinding of the leverage bubble triggered by the historically low rates enigineered by former Fed chairman Alan Greenspan and the near simultaneous defense spending explosion of the Afghanistan and Iraq conflicts, as well as the cyclical downturn, which is gaining momentum and generating higher unemployment and layoffs.

(Watch the accompanying video to see what Pimco's co-CEO El-Erian has to say...)

Earlier this month, the Congressional Budget Office’s issued its baseline ten-year budget projections—which assume no policy changes over the period—and forecast that debt held by the public would explode from $5.4 trillion in calendar year 2008 to $7.9 trillion in 2018.

Add to that, the government’s series of credit crunch crisis moves culminating in the Treasury plan and you have another $1.8 trillion at the minimum.

Hanke, who adamantly opposes the Treasury’s bailout plan, says the lessons of the Iraq-Afghanistan wars certainly apply and that uncertainly about the plan, as well as setbacks and/or outright failure.

“There will be lots of uncertainty to it,” he says. “Just think of the sentiment about the war on terrorism and how that deteriorated over time with bad performance. The same thing happens in the financial sector. There’s a huge overhang on the consumer side.”

That’s especially problematic at a time when consumer spending is slowing—along with tax receipts from most corners of the economy—and the economy is expected to begin contracting as soon as the fourth quarter.

There’s also little chance of austerity with a new administration. Sticker shock about the bailout aside, the two contenders remain wedded to their economic proposals, none of which are likely to provide budget relief.

Hanke says “substantial increases in spending, put the economy on an unsustainable path.”